P2.T7. Operational & Integrated Risk Management Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools Bionic Turtle FRM Study Notes By David Harper, CFA FRM CIPM www.bionicturtle.com
Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools DEFINE AND DESCRIBE THE MINIMUM LIQUIDITY COVERAGE RATIO.... 5 DESCRIBE THE CHARACTERISTICS OF HIGH QUALITY LIQUID ASSETS (HQLA) AND OPERATIONAL REQUIREMENTS FOR ASSETS TO QUALIFY AS HQLA.... 5 2
Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools Define and describe the minimum liquidity coverage ratio. Describe the characteristics of high quality liquid assets (HQLA) and operational requirements for assets to qualify as HQLA. Differentiate between Level 1, Level 2A, and Level 2B assets, and define the respective cap for each asset class as a percentage of total HQLA. Define how total net cash outflows are calculated for the minimum liquidity coverage ratio. Describe additional metrics to be used by supervisors as monitoring tools when assessing the liquidity risk of a bank. Introduction During the early liquidity phase of the financial crisis that began in 2007, many banks experienced difficulties because they did not manage their liquidity. Prior to the crisis, asset markets were buoyant and funding was readily available at low cost. The crisis drove home the importance of liquidity to the proper functioning of financial markets and the banking sector. The rapid reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time. The banking system came under severe stress, which necessitated central bank action to support both the functioning of money markets and, in some cases, individual institutions. To complement [the Principles for Sound Liquidity Risk Management and Supervision, previously published in 2008] the Committee has further strengthened its liquidity framework by developing two minimum standards for funding liquidity. These standards have been developed to achieve two separate but complementary objectives. The first objective is to promote short-term resilience of a bank s liquidity risk profile by ensuring that it has sufficient high-quality liquid assets to survive a significant stress scenario lasting for one month. The Committee developed the Liquidity Coverage Ratio (LCR) to achieve this objective. The second objective is to promote resilience over a longer time horizon by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing basis. The Net Stable Funding Ratio (NSFR) has a time horizon of one year and has been developed to provide a sustainable maturity structure of assets and liabilities. 3
Given that the LCR is insufficient to measure all dimensions of a bank s liquidity profile, the Committee developed a set of monitoring tools to strengthen and promote global consistency in liquidity risk supervision. These tools are supplementary and are to be used for monitoring of the liquidity risk exposures of banks, and in communicating these exposures among home and host supervisors. The Committee introduced phase-in arrangements to implement the LCR to ensure that the banking sector can meet the standard through reasonable measures, while still supporting lending to the economy. The Committee remained firmly of the view that the LCR is an essential component of the set of reforms introduced by Basel III and will help deliver a more robust and resilient banking system. The Committee was also mindful of the implications of the standard for financial markets, credit extension and economic growth, and of introducing the LCR at a time of ongoing strains in some banking systems. It decided to provide for a phased introduction of the LCR, in a manner similar to that of the Basel III capital adequacy requirements. On September 3, 2014, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Federal Reserve Board), and the Federal Deposit Insurance Corporation issued a final rule that implements a quantitative liquidity requirement consistent with the liquidity coverage ratio (LCR) established by the Basel Committee on Banking Supervision (BCBS). The final rule applies to internationally active banking organizations; those with $250 billion or more in total consolidated assets or $10 billion or more in on-balance-sheet foreign exposure and to any consolidated bank or savings association subsidiary of one of these companies that has total consolidated assets of $10 billion or more. The final rule does not apply to bank holding companies or savings and loan holding companies with substantial insurance operations, to bridge banks that may be used in the course of bank resolutions, or to federal branches and agencies. The Federal Reserve Board separately adopted a less stringent, modified LCR requirement for bank holding companies and savings and loan holding companies without significant insurance or commercial operations that have $50 billion or more in total consolidated assets but are not internationally active. The final rule was effective on January 1, 2015: o Defines three categories of HQLA level 1, level 2A, and level 2B liquid assets and sets forth qualifying criteria and compositional limitations for an asset s inclusion in the HQLA amount (the LCR numerator). o Includes an approach for calculating a covered company s total net cash outflows (the LCR denominator) to address potential maturity mismatches in the company s outflows and inflows within the 30-calendar-day period. o Requires a covered company to notify its appropriate federal banking agency on any calculation date when its LCR is less than the minimum requirement and to submit a remediation plan if the shortfall persists. o Requires covered companies to comply with the minimum LCR standard as follows: 60% in 2015, 70% in 2016, 80% in 2017, 90% in 2018, and 100% in 2019. 4
The Committee also reaffirmed its view that, during periods of stress, it would be entirely appropriate for banks to use their stock of HQLA, thereby falling below the minimum. Supervisors will subsequently assess this situation and will give guidance on usability according to circumstances. Furthermore, individual countries that are receiving financial support for macroeconomic and structural reform purposes may choose a different implementation schedule for their national banking systems, consistent with the design of their broader economic restructuring program. It remains the Committee s intention that the NSFR, including any revisions, will become a minimum standard by 1 January 2018. Define and describe the minimum liquidity coverage ratio. Minimum liquidity coverage ratio (LCR) is the minimum amount of funds that a bank must maintain in the form of high-quality liquid assets, which can be converted into cash to meet liquidity needs for a 30 calendar day time horizon under a significantly severe liquidity stress scenario specified by supervisors. Liquidity coverage ratio (LCR): % Describe the characteristics of high quality liquid assets (HQLA) and operational requirements for assets to qualify as HQLA. Assets are considered to be high quality liquid assets (HQLA) if they can be easily and immediately converted into cash at little or no loss of value. The liquidity of an asset depends on the underlying stress scenario, the volume to be monetized and the timeframe considered. Fundamental Characteristics Low credit and market risk: assets that are less risky tend to have higher liquidity. High credit standing of the issuer and a low degree of subordination increase an asset s liquidity. Low duration, low legal risk, low inflation risk and denomination in a convertible currency with low foreign exchange risk all enhance an asset s liquidity. Ease and certainty of valuation: an asset s liquidity increases if market participants are more likely to agree on its valuation. Assets with more standardized, homogenous and simple structures tend to be more fungible, promoting liquidity. The pricing formula of a high-quality liquid asset must be easy to calculate and not depend on strong assumptions. The inputs into the pricing formula must also be publicly available. In practice, this should rule out the inclusion of most structured or exotic products. Low correlation with risky assets: the stock of HQLA should not be subject to wrong-way (highly correlated) risk. For example, assets issued by financial institutions are more likely to be illiquid in times of liquidity stress in the banking sector. Listed on a developed and recognized exchange: being listed increases an asset s transparency. 5
Market-related Characteristics Active and sizable market: the asset should have active outright sale or repo markets at all times. There should be historical evidence of market breadth and market depth. This could be demonstrated by low bid-ask spreads, high trading volumes, and a large and diverse number of market participants. Diversity of market participants reduces market concentration and increases the reliability of the liquidity in the market. Presence of committed market makers: There should be robust market infrastructure in place. The presence of multiple committed market makers increases liquidity as quotes will most likely be available for buying or selling HQLA Low market concentration Low volatility: Assets whose prices remain relatively stable and are less prone to sharp price declines over time will have a lower probability of triggering forced sales to meet liquidity requirements. Volatility of traded prices and spreads are simple proxy measures of market volatility. There should be historical evidence of relative stability of market terms (eg prices and haircuts) and volumes during stressed periods. Flight to quality: historically, the market has shown tendencies to move into these types of assets in a systemic crisis. The correlation between proxies of market liquidity and banking system stress is one simple measure that could be used. The test of whether liquid assets are of high quality is that, by way of sale or repo, their liquidity-generating capacity is assumed to remain intact even in periods of severe idiosyncratic and market stress. Operational Requirements A bank should periodically monetize a representative proportion of the assets in the stock through repo or outright sale, in order to test its access to the market, the effectiveness of its processes for monetization, the availability of the assets, and to minimize the risk of negative signaling during a period of actual stress. All assets in the stock should be unencumbered. The asset should be free of legal, regulatory, contractual or other restrictions on the ability of the bank to liquidate, sell, transfer, or assign the asset. A bank should exclude from the stock those assets that the bank would not have the operational capability to monetize to meet outflows during the stress period. The stock should be under the control of the function charged with managing the liquidity of the bank, meaning the function has the continuous authority, and legal and operational capability, to monetize any asset in the stock. NOTE: An asset should not be included in the stock if the sale of that asset, without replacement throughout the 30-day period, would remove a hedge that would create an open risk position in excess of internal limits. A bank is permitted to hedge the market risk associated with ownership of the stock of HQLA and still include the assets in the stock. If it chooses to hedge the market risk, the bank should take into account the cash outflow that would arise if the hedge were to be closed out early. A bank should have a policy in place that identifies legal entities, geographical locations, currencies and specific custodial or bank accounts where HQLA are held to ensure that HQLA are mobilized in a timely manner when needed. 6
Qualifying HQLA that are held to meet statutory liquidity requirements at the legal entity or sub-consolidated level may only be included in the stock at the consolidated level to the extent that the related risks are also reflected in the consolidated LCR. o Any surplus of HQLA held at the legal entity can only be included in the consolidated stock if those assets would also be freely available to the consolidated (parent) entity in times of stress. In assessing whether assets are freely transferable for regulatory purposes, banks should be aware that assets may not be freely available to the consolidated entity due to regulatory, legal, tax, accounting or other impediments. o Assets held in legal entities without market access should only be included to the extent that they can be freely transferred to other entities that could monetize the assets. In certain jurisdictions, large, deep and active repo markets do not exist for eligible asset classes, and therefore such assets are likely to be monetized through outright sale. o In these circumstances, a bank should exclude from the stock of HQLA those assets where there are impediments to sale, such as large fire-sale discounts which would cause it to breach minimum solvency requirements, or requirements to hold such assets, including statutory minimum inventory requirements for market making. Banks should not include in the stock of HQLA any assets, or liquidity generated from assets, they have received under right of re-hypothecation, if the beneficial owner has the contractual right to withdraw those assets during the 30-day stress period. Assets received as collateral for derivatives transactions that are not segregated and are legally able to be rehypothecated may be included in the stock of HQLA provided that the bank records an appropriate outflow for associated risks. A bank should manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and contribute to the smooth functioning of payment and settlement systems. While the LCR is expected to be met and reported in a single currency, banks are expected to be able to meet their liquidity needs in each currency and maintain HQLA consistent with the distribution of their liquidity needs by currency. The bank should be able to use the stock to generate liquidity in the currency and jurisdiction in which the net cash outflows arise. In order to mitigate cliff effects that could arise, if an eligible liquid asset became ineligible, a bank is permitted to keep such assets in its stock of liquid assets for an additional 30 calendar days. This would allow the bank additional time to adjust its stock as needed or replace the asset. 7